Keys to Capital in 2012 Capital is King (New Rules Old Challenges)

Transcription

1 Keys to Capital in 2012 Capital is King (New Rules Old Challenges) 2012 Banking Institute University of North Carolina School of Law Center for Banking and Finance March 29, 2012 Presented by: Edwin S. del Hierro Kirkland & Ellis LLP Carol A. Hitselberger Mayer Brown LLP Charles M. Horn Morrison & Foerster LLP Karol K. Sparks Barack Ferrazzano (Coordinator)

2 Introduction Basics 2

3 Capital Requirements History Increasingly Sophisticated Approach 1983 capital rules Market risk recognized in Basel risk-based capital guidelines capture off-balance sheet items Basel II proposal to capture more types of risk Basel III (2012) > more capital & more tangible common capital Rules include Regulations and Guidelines 3

4 How Important is Capital? CAMELS rating: depository institutions Capital Assets Management E arnings L iquidity Sensitivity to risk RFI/C(D): holding companies Risk Financial condition Impact on the subsidiary bank(s) Composite p for the FHC and rating of each insured (D) epository 4

5 Capital Ratio Requirements Capital Ratios Current Rules Leverage Capital Ratio Tier 1 Capital/Total average assets Tier 1 Risk-based Capital Ratio Tier 1 Capital/Total risk-weighted assets Total Risk-based Capital Ratio Qualifying Total Capital (Tier 1 and Tier 2)/Total risk-weighted assets Minimum Requirements e e Current Rules Adequately Capitalized Well Capitalized Leverage Capital Ratio Tier 1 Risk-based Capital Ratio.. Total Risk-based Capital Ratio... 3% / 4% 4% 8% 5% 6% 10% Ratios improve if you Increase Capital or Decrease Assets 5

6 Capital Ratio Requirements (continued) Basel III New Rules Focus on quality of capital (Tier 1 Common Equity Capital T1 CE) Deduction for goodwill and other intangibles (other than MSBs), DTAs, investments in stock of unconsolidated subsidiaries, etc. Table below does not include counter-cyclical capital buffer of up to 2.5% or additional capital ranging from 1% to 2.5% required for G-SIBs 2011 (B II) (B III) Common Equity Capital Ratio Capital Conservation Buffer Common Equity plus Capital Conservation Buffer 2.0% 2.0% 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% 0% 0% 0% 0% 0% 0.625% 1.25% 1.875% 2.5% 2.0% 2.0% 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Phase-in of deductions 0% 0% 0% 20% 40% 60% 80% 100% 100% Tier 1 Capital/RWAs 4.0% 4.0% 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Total Capital/RWAs 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Total Capital plus Capital Conservation Buffer 80% 8.0% 80% 8.0% 80% 8.0% 80% 8.0% 80% 8.0% 8.625% 9.25% 9.875% 10.5% 6

7 Capital Ratio Requirements (continued) Basel III Key Provisions Components of capital Risk coverage Leverage ratio Liquidity coverage requirements Pillar 2 risk management and supervision Pillar 3 market discipline 7

8 Capital Ratio Requirements (continued) Chart prepared by BCBS and available at 8

9 Capital Ratio Requirements (continued) Dodd-Frank and Basel III Implementation Basel III is expected to refine G-SIB requirements during late 2011 or early 2012 (additional T1 CE of 1% to 2.5% of RWAs) Section 939A of Dodd-Frank requires that regulators review references to NRSROs in regulations Section 171 of Dodd-Frank (Collins Amendment) requires the exclusion of cumulative preferred and trust preferred from Tier 1 Applies to institutions with consolidated assets of greater than $15 billion Three-year phase-in starting in 2013 Technically applies to intermediate bank holding companies that are subsidiaries of non-u.s. organizations December 15 Federal Reserve rulemaking regarding capital standards for trading activities is not fully consistent with Basel III 9

10 Capital Ratio Requirements (continued) Dodd-Frank and Basel III Implementation (continued) Current U.S. regulatory intentions with respect to implementation of Basel III: Adoption of 6-year transition period for Basel III requirements U.S. banking organizations would not be expected to meet fully phased-in Basel III requirements prior to their effective times, but would be expected to: take affirmative steps to increase capital levels in order to meet applicable deadlines, and improve their capital ratios through prudent earnings retention policies U.S. may look to progress towards Basel III in evaluating capital adequacy for various purposes p 10

11 Special and Practical Considerations Basel III and Dodd-Frank Implementation Capital funding at the holding company is typically contributed to the depository institution as Tier 1 common equity capital Special capital rules for TARP issuers, SBLF issuers and small bank holding companies (under $500 million in total assets) Enforcement actions which may increase minimum requirements Financial holding company status Application of FDIC Statement of Policy Prior commitments to regulators Covenants in commercial agreements Loan and other financing documents Special rules in the capital regulations Direct credit substitutes risk weighting adjustment Non-financial equity investments deduction from core capital elements (Tier 1 capital) Others 11

12 Tier 1 Capital (core capital elements) General requirements (pre-basel III) Tier 1 capital must represent at least 50% of total capital Voting common stock must be the dominant element within Tier 1 All capital instruments must be fully paid-up and effectively unsecured Banking organization may not provide funding for its own capital instruments In general, Tier 1 and Tier 2 capital must be subordinate to senior indebtedness and, if issued by depository institution, depositors Components (pre-basel III) Common stockholders equity Non-cumulative preferred stock (including any related surplus); includes TARP preferred Minority interests issuances by consolidated depository institutional (non-cumulative perpetual preferred) Restricted core capital elements Qualifying cumulative perpetual preferred stock Minority interests issuances by consolidated depository institutions (cumulative perpetual preferred) Minority interests issuances by non-depository institutions (common or perpetual preferred) Trust preferred securities for institutions with total assets of less than $15 billion 12

13 Tier 1 Capital (calculation) Sum of core capital elements Reduced by: Goodwill Other intangibles Interest-only strip receivables Deferred tax assets Non-financial equity investments Other items Pre-Basel III 13

14 Tier 2 Capital (supplementary capital) General requirements (pre-basel III) May not exceed 100% of Tier 1 capital Components (pre-basel III) Allowance for loan and lease losses (limited to 1.25% of risk-weighted assets) Perpetual preferred stock Excess amounts of cumulative and non-cumulative Auction-rate preferred stock Hybrid capital instruments; t perpetual debt; mandatorily convertible debt securities Term subordinated debt; intermediate term preferred stock (limited to 50% of Tier 1 and amortized during 5-year period immediately prior to maturity) 14

15 Total Capital (calculation) Sum of Tier 1 and Tier 2 capital Reduced by: 50% of capital investments t in unconsolidated d banking and finance subsidiaries i Reciprocal holdings of other banking organizations Other deductions (case-by-case) Pre-Basel III 15

16 Total Assets Leverage Ratio Use book assets, no conversion or weighting is necessary Use average over the quarter rather than quarter-end Look to call report or FRY-9 16

17 Risk-weighted Assets Currently for Risk Weighting (modified Basel I): 0% includes cash, claims on governments of OECD countries, agencies of U.S. with full faith and credit of U.S. government 20% includes claims against U.S. depository institutions and OECD banks, general obligation municipal bonds, U.S. agencies, World Bank 50% includes 1-4 4family mortgage loans, certain multifamily lif il mortgage loans, municipal i revenue bonds ABS (optional): ratings dependent 100% includes all else Other assets Non-financial equity interests Direct credit substitutes Subordinated interest Sub-prime assets 17

18 Risk-weighted Assets Off-balance Sheet Assets Off-balance sheet items are converted at four different rates and then placed into one of the four risk-weighted categories (modified Basel I): 0% conversion factor for unused portions of commitments of less than a year; right to cancel (more recently changed to 10% in U.S.) 20% conversion factor for short-term, self-liquidating trade contingencies, commercial letter of credit 50% conversion for bid bonds, performance bonds, standby letter of credit for a particular transaction; commitments of more than a year (home equity lines) 100% conversion for guarantees, financial standby letter of credit 18

19 Risk-weighted Assets Unsecuritized ii Exposures Wholesale Risk adjusted amounts determined by IRB bank inputs (PD, LGD, EAD and M) for individual exposures Retail Risk adjusted amounts determined by bank inputs (PD, LGD, EAD) for retail segments (e.g., residential mortgage loans, qualifying revolvers, other) Modified Basel I Standardized 100% for everything except governments, banks and international organizations RBA for most wholesale exposures 50% for residential mortgage loans; 100% for everything else LTV scale for residential mortgages; 75% for regulatory retail and 100% for other retail 19

20 Risk-weighted Assets Securitization Exposures IRB hierarchy Ratings Based Approach - mandatory if external rating, else inferred rating (if available) Inferred rating refers to external rating of another securitization exposure to subordinated obligation of same issuer with same underlying assets, having no credit enhancement that is unavailable to unrated exposure and having a remaining maturity equal to or longer than the unrated exposure. This rating (if available) must be imputed to the unrated exposure Supervisory Formula (if all data available) Otherwise deduction from capital (exception for IAA applicable to certain conduit exposures) 20

21 Ratings Based Approach Long Term Ratings* Current Risk Weights Risk Weights Under US Final Rules Granular Pool Senior Exposure Non-Senior Exposure Non-Granular Pool AAA 20% 7% 12% 20% AA 8% 15% 25% A+ 50% 10% 18% A 12% 20% 35% A- 20% 35% BBB+ 100% 35% 50% BBB 60% 75% BBB- 100% BB+ 200% 250% BB 425% BB- 650% B, below or unrated RBA Not Available Deduct from tier 1 and tier 2 capital Short Term Ratings A-1 20% 7% 12% 20% A-2 50% 12% 20% 35% A-3 100% 60% 75% 75% * For investing banks, one rating is sufficient. If there are multiple ratings on a particular position, the lowest solicited rating governs. 21

22 Securitization Capital Charges The SFA capital requirement for a securitization exposure is UE (underlying exposure) multiplied by TP multiplied by the greater of (i) * T; or (ii) S[L+T] - S[L], where: 22

23 Resecuritzation Issues Resecuritization (or Resecuritisation ) under IRB Appendix is defined as (in Section 541(i)): A resecuritization exposure is a securitization exposure in which the risk associated with an underlying pool of exposures is tranched and at least one of the underlying exposures is a securitization exposure. In addition, an exposure to one or more resecuritization exposures is a resecuritization exposure. 23

24 Analytical Approach to Addressing Capital Needs 24

25 Initial Considerations Review detailed capital calculation at holding company and at insured depository institutions Review ew call reports, reports of examination, SEC filings, enforcement e actions, agreements with change of control provisions, etc. Determine whether capital need is at depository institution or holding company Make realistic assessment of timeline if regulatory issues exist Determine whether need can be addressed by Tier 1 or Tier 2 capital Determine whether significant changes in asset composition or asset levels will occur prior to, or in connection with, capital formation Evaluate alternatives based on current market conditions Evaluate limitations it ti or requirements relating to TARP or SBLF participation i Determine whether insiders and current shareholders will participate 25

26 Initial Considerations (continued) Determine whether fairness opinion will be required or may be prudent Determine whether it is realistic to approach professional investors Determine whether shareholder approvals will be required Evaluate limitations based on characteristics of the organization and its current equity capital platform and debt obligations Evaluate alternatives to sell business divisions or to create joint venture arrangements (capital treatment for minority interests at subsidiaries) Consider challenges created dby trust tpreferred securities Consider challenges created by regulatory developments 26

27 Market/Investor Perspective Growth Combination Survival Institution Characteristics Finance an opportunity Public market access uncertain New capital fills the hole in Trading at a premium valuation Valuation reflects market the balance sheet and limits risk Adequate capital and reserves as uncertainty and offers of failure stand alone significant upside Typically trading at a Limited exposure to higher risk Material asset quality issues significant discount to tangible book value asset classes Strong core franchise Respected management team Survival assured, position for long term success Attractive core franchise value Respected management team with opportunity to upgrade New capital assures survival New capital facilitates pursuit of core strategy Distressed asset quality, operational issues and management issues Franchise value sufficient to attract capital Use of Proceeds Offensive use of capital repay TARP and strategic acquisitions Lead investor must offer support for strategic direction Lead investor due diligence must create credibility Lead investor must address identified weaknesses and offer credible path to improvements Lead investor requires improvements in management and operations Lead investor must interact with regulators to address regulatory intervention 27

28 Capital Instruments Common Stock Advantages Tier 1 Capital Foundation of Capital Base Increase Float/Exposure May Be Accretive to Book Value Disadvantages Highest Cost of Capital Most Dilutive to Earnings Difficult During Periods of Market Volatility Offering May Pressure Price Non-Cumulative Convertible Preferred Tier 1 Capital Equivalent to Common Over Time Increases Float More Attractive Dividend Rate Dividend Not Tax-Deductible Dilutes Existing Common Shares Upon Conversion Structure can be Complex Non-Cumulative Perpetual Preferred Tier 1 Capital Callable at Par Fixed or Floating Dividend Increases Capacity for Trust Preferred Dividend Not Tax-Deductible Can Create Pressure on Common Dividend Not Required Bank or BHC Tier 2 Subordinated Debt Lowest Cost of Capital Tier 2 Treatment at Issuer Tax Deductible Callable at Par Can be Tier 1 at Bank if BHC is Issuer Tier 2 Treatment at Issuer Short-term Capital Capital Treatment Limited During Last 5 Years Cumulative Perpetual Redeemable Preferred Tier 2 Treatment at Issuer No Dilution to Shareholders Fixed or Floating Coupon Callable at Par Cash Flow Requirement Dividend Not Tax-Deductible Can Create Pressure on Common 28

29 Institutional Capital Products Lending/investing by money-center banks, insurance companies and other institutions Senior holding company debt (secured or unsecured) Capital-qualified subordinated debt Depository institution level (accounting consolidation can create holding company capital) Holding company level Risk mitigation arrangements to facilitate t financing i Repurchase and liquidity arrangements Other support from significant shareholders 29

30 Typical Transaction Timeline Key Event Week * Organizational Meeting Due Diligence Process (Third-Party Loan Review) Prepare the Marketing Materials Refine the Projections Finalize Structure Develop Investor List Pre-Market Transaction Prepare Anchor Investor Presentation Anchor Investor Presentations (Third-Party Loan Review) Investor Meetings Investor Due Diligence (Third-Party Loan Review) Documentation Closing* * Closing would be delayed for between days if a Notice under the Change in Bank Control Act is required or if a non-control determination under the Bank Holding Company Act is requested. * * 30

31 Transaction Issues Public Offering Valuation and tax analysis Third-party loan review Application of Section 382 limitations Investment banks/underwriters Size of the offering Access to institutional tional investors Ability to execute within appropriate time frame Equity or debt instrument Disclosure issues Regulatory developments Asset quality trends Impact of Dodd-Frank and Basel III Coordinate with required shareholder and other approvals SEC review of proxy materials 31

32 Transaction Issues Public Offering (continued) Coordinate with the U.S. Treasury Dilution to current shareholders Rights offerings Shareholder approvals Shareholder communications Banking regulator involvement FRB, OCC, FDIC, state authorities Applications, notices and other submissions Coordinate with sale of non-performing loans and other assets Implementation Registration statement SEC review of registration statement 32

33 Transaction Issues Private Placement Valuation and tax analysis Third-party loan review Application of Section 382 limitations Anti-dilution protection Indemnification rights Transaction fees; expense reimbursement Minority investor rights Registration rights Tag-along and drag-along rights Board/committee representation Board observation rights Disclosure issues 33

34 Transaction Issues Private Placement (continued) Post-investment covenants Capital formation Information rights Operational and strategic matters Executive compensation Coordinate with the U.S. Treasury Coordinate with sale of non-performing loans and other assets Coordination with FRB and FDIC statements of policy and passivity and nonassociation commitments 34

35 Implementation Private Placement Determine number of investors and amount of the aggregate investment Confirm exemption from registration requirements Transaction documents Investment Agreement or Stock Purchase Agreement Registration Rights Agreement Documents that create the security Other documents Offering memorandum Shareholder agreement Subscription agreement Coordinate necessary shareholder and other approvals Coordinate fairness opinion Coordinate with sale of non-performing loans and other assets Banking regulator involvement FRB, OCC, FDIC, State Authorities Applications, notices and other submissionsss s 35

36 Discussion Common Stock Transaction Preferred Stock Transaction Senior or Subordinated Debt Transaction 36

37 Long Term Impact Small/mid-sized institutions will continue to encounter challenges in raising capital From 2005 to 2010, institutions over $100 billion grew by 49%; institutions between $10 billion and $100 billion shrank by 30% Dividends will continue to be limited as these institutions retain earnings to comply with enhanced capital requirements Only publicly traded companies will be successful acquirers Transaction funding for small/mid-sized sized institutions has disappeared Pricing multiples for small/mid-sized institutions will diverge from regionals and large institutions Consolidation will be slower than anticipated as healthy mid-sized institutions and regionals build capital Regulatory policies will continue to make investments by private equity difficult 37

38 Long Term Impact (continued) Note: Data reflects bank and thrift operating units. Assets have been adjusted for inflation by translating prior years to the level of the consumer price index at December Source: Federal Deposit Insurance Corp. 38

39 Appendices: APPENDIX A Capital Markets Environment APPENDIX B Overview of Regulation and Regulators APPENDIX C Control, FRB and FDIC Policy Statements APPENDIX D Regulatory Reform Special Notes: The presenter(s) acknowledge and thank Allen G. Laufenberg and Stifel Nicolaus for their contribution to, and assistance with, the preparation of the materials in APPENDIX A Capital Markets Environment. APPENDIX D Regulatory Reform was prepared and contributed by Charles M. Horn of Morrison & Foerster LLP. 39

40 APPENDIX A Capital Markets Environment Tier 1 Capital Raising Activity Capital raising activity for banks and thrifts declined significantly in 2011 as compared to the prior three years SBLF funded approximately $4 billion out of a potential $30 billion dedicated to the program Total lcapital lraised by Banks &Th Thrifts Cumulative Capital Raised ( ) lions) ($ Bill Source: SNL Financial Trust Preferred Preferred Common Equity TARP Preferred SBLF Common & Preferred Trust Preferred TARP/SBLF 40

41 APPENDIX A Capital Markets Environment Bank and Thrift Common Offerings Bank & Thrift Public Common Stock Offerings $ $ $ $80 80 $60 60 $40 40 $20 20 $ Source: SNL Financial. Public ($M) Number of Public Deals 41

42 APPENDIX A Capital Markets Environment Equity Market Conditions US debt downgrade in August 2011 had a significant impact on momentum that had built off March 2009 lows: S&P Bank Index is up 138% NASDAQ Bank Index is up 37%; smaller banks continue to lag large banks S&P 500 is up 86% 60% Three Year Price Performance 40% 39.2% 20% 0% (20%) (5.1%) (20.1%) (40%) (60%) (80%) 12/31/08 6/30/09 12/31/09 6/30/10 12/31/10 6/30/11 12/31/11 Source: SNL Financial. S&P 500 S&P Bank NASDAQ Bank 42

43 APPENDIX A Capital Markets Environment Valuation Levels Near Historical Lows Median Price to Tangible Book Value Multiples 300% 279% 250% 200% Overall Average: 177% 150% 86% 100% 120% 50% 0% 1990Q1 1992Q1 1993Q4 1995Q4 1997Q4 1999Q4 2001Q4 2003Q4 2005Q4 2007Q4 2009Q4 2011Q4 Valuations have remained depressed after bottoming out in early 2009 and are well bl below the 20-year norm Shading in the above chart references periods of economic recession. Percentage of Institutions Trading Below Tangible Book Value 100% US Debt Downgraded 90% from AAA 80% 70% 60% 50% 40% 30% 20% 10% 0% 1990Q1 1992Q1 1993Q4 1995Q4 1997Q4 1999Q4 2001Q4 2003Q4 2005Q4 2007Q4 2009Q4 2011Q4 Source: SNL Financial as of 3/9/12. Includes institutions with assets greater than $1 billion as of the most recently reported quarter (includes acquired & defunct institutions). 34% There are currently 88 institutions with assets greater than $1 billion trading below tangible book value 43

44 APPENDIX A Capital Markets Environment Trust Preferred TruPS Offerings Banks & Thrifts ($B) No longer an option as a result of the Collins Amendment to Dodd-Frank Investors focus is now on tangible common equity levels with appropriate amounts of leverage Leverage is unavailable to the vast majority of the community banking industry Source: SNL Financial. 44

45 APPENDIX A Capital Markets Environment Historical Bank and Thrift Failures Compelling FDIC-assisted transactions have become more scarce, increasing competition for attractive franchises and prompting some buyers to begin looking to traditional M&A for growth FDIC Problem List has declined to 813 from a high of 884 institutions Source: SNL Financial and FDIC. 45

46 APPENDIX B Overview of Current Regulation Financial Holding Company State State Federal State Special Bank Broker/ Futures National Life member nonmember thrift financing holding dealer commission bank bank bank entity company merchant thrift/ holding company insurance company (broker/agent/ underwriter) Commercial paper funding corporation Non-U.S. commercial bank Bank Asset management company Non-U.S. investment bank Futures commission merchant U.S. securities broker/dealer/ underwriter Insurance agencies U.S. federal regulators CFTC CFPB OCC* OTS* Other State regulator Non-U.S. regulator Non-U.S. securities broker/dealer/ underwriter FDIC SEC Unregulated Federal Reserve* SRO *Dodd-Frank eliminated the OTS, transferred supervision of federal thrifts to OCC, subjected thrift holding companies to Federal Reserve supervision and created the Financial Stability Oversight Council and the Consumer Financial Protection Bureau. Source: U.S. Government Accountability Office, Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and Across System, July 22,

47 APPENDIX B Regulators Regulations Federal Reserve (Reserve Banks and the Reserve Board) 12 CFR 225 (Appendix C) state member banks and bank holding companies 12 CFR 567 thrift holding companies General information Created by Congress with the passage of the Federal Reserve Act in 1913 Consists of 12 Federal Reserve Banks located throughout the country Run by seven member Board of Governors that is appointed by the President for 14-year terms (President appoints Chairman and Vice Chairman for 4-year terms) Primary federal regulator of all bank holding companies Effective July 21, 2011, primary federal regulator of all thrift holding companies Primary federal regulator for state-chartered banks that choose to become Federal Reserve members (approximately 845) Source: The 96 th Annual Report 2009, Board of Governors of the Federal Reserve System 47

48 APPENDIX B Regulators Regulations Office of the Comptroller of the Currency 12 CFR 3 (Appendix C) national banks 12 CFR 567 federal thrifts General information Created by the National Bank Act in 1863 Bureau of the Treasury Department Comptroller is appointed by the President, with the advice and consent of the Senate, for a five-year term Charters, regulates and supervises all national banks (approximately 1,485) Effective July 21, 2011, primary federal regulator of all federal savings and loan associations and federal savings banks (approximately 800) Sources: The Annual Report of the Office of the Comptroller of the Currency, FY 2010, The Annual Report for the Office of Thrift Supervision, FY

49 APPENDIX B Regulators Regulations Federal Deposit Insurance Corporation state non-member banks and state chartered thrifts 12 CFR 325 (Appendix C) General information Created in 1933 Independent federal agency managed by a five-member board of directors appointed by the President and confirmed by the Senate (includes Comptroller (OCC)) Funds its operations and its insurance activities from deposit insurance premiums paid by insured depository institutions Insurer of all federally insured depository institutions including almost all banks and thrifts Receiver or conservator for all failed federally insured depository institutions Primary federal regulator of state non-member banks (approximately 4,475) Effective July 21, 2011, primary federal regulator of state chartered thrifts (approximately 60) Source: Under New Management, Thrifts Must Get in Line, The American Banker, February 4,

50 APPENDIX C Avoiding Control A company that directly or indirectly controls a bank (or a bank holding company) becomes a bank holding company (BHC). BHC status has significant adverse consequences that would typically be unacceptable for most professional investors, including: Limitations on activities and investments Significant regulation Supervision i and examination i by the Federal lreserve Capital requirements Restrictions on the ability to incur debt 50

51 APPENDIX C Avoiding Control (continued) The FRB has taken a very expansive view of what constitutes controlling influence and control and considers the following factors: Percentage of voting securities Percentage of equity Operational or other covenants Business relationships Right to appoint directors or officers Right to appoint board observers 51

52 APPENDIX C Avoiding Control (continued) Control is broadly defined and difficult to avoid if investor: Acquires direct or indirect control of 25% or more of any class of voting securities of a bank or BHC Controls the election of a majority of the board of directors of the bank or BHC Has the power to directly or indirectly exercise a controlling influence over the management or policies of the bank or BHC 52

53 APPENDIX C FRB Policy Statement On September 22, 2008, the Federal Reserve Board (FRB) issued a Policy Statement t t that t relaxes certain long-standing policies i on minority it equity investments, including allowing investors: To make passive minority investments of up to 33% of total equity without being considered d in control, if certain conditions are met; To have one board seat [and up to two board seats on the target s board under certain conditions]; To obtain updates from the target s management on key issues and to participate in discussion of these issues with the target s management and board of directors; and To have additional business relationships than previously allowed, if the investment is closer to 10% than to 25% of the total voting securities of the organization. 53

54 APPENDIX C FRB Policy Statement (continued) The Policy Statement relaxes limitations imposed on investors by: Allowing total passive investments in banks and BHCs of up to 33% (from 24.9%) of total equity. The FRB will permit an investor to acquire a combination of voting and nonvoting shares that aggregate less than 1/3 of the total equity of the target bank or BHC, provided that the investor does not acquire 15% or more of any class of voting securities es (assuming all convertible non-voting shares held by the investor were converted). Note that, as in the past, non-voting convertible shares held by a passive investor must remain non-voting in the hands of that investor and may only be transferred (i) to an affiliate of the investor or to the target; (ii) in a widespread public offering; (iii) in transfers in which no transferee (or group) would receive 2% or more of any class of voting securities, or (iv) to a transferee that already controls more than 50% of the voting securities of the target. Note also that any passive investor would continue to be restricted to acquiring only up to 24.9% of any class of voting securities without being considered in control of the target bank or BHC. 54

55 APPENDIX C FRB Policy Statement (continued) The Policy Statement relaxes limitations imposed on investors by: Allowing a private equity investor to have director representation. A minority investor may name one director regardless of the size of its minority investment, [and may name up to two directors total, if: (i) the board has at least eight voting members; (ii) the investor s board representation is proportionate to its total interest in the target; and (iii) another shareholder of the target is a BHC that controls the target]. In addition, the investor s representative may not chair the board or any committee of the board, and may serve as a board committee member only if the representatives of the minority investor do not account for more than 25% of fthe committee members and do not thave the authority or practical ability unilaterally to bind the board or management. 55

56 APPENDIX C FRB Policy Statement (continued) The Policy Statement relaxes limitations imposed on investors by: Allowing input from investors into bank or BHC business decisions. The FRB in the past limited the ability of a passive investor to have any influence over the business or operations of the target bank or BHC. The FRB now permits non-controlling minority investors to communicate with management about (and advocate for) changes in the target s policies and operations, including changes to dividend policies, debt and equity financing strategies, business line operations, mergers or other acquisitions transactions, and even management. However: Investors subject to any passivity agreement with the FRB may not solicit proxies against management or threaten to sell shares as part of any attempt to influence management, and Minority investors may not obtain covenants from the target that would limit the target management s discretion over major policies and decisions. Generally not permitted: Covenants regarding hiring, firing and compensation of executive officers, engaging in new lines of business, merging or consolidating entities, raising additional capital, selling or acquiring assets Generally permitted: Prohibitions on issuing senior securities, modifying terms of investor ss securities, or liquidating the target, or information and consultation rights. 56

57 APPENDIX C FRB Policy Statement (continued) The Policy Statement relaxes limitations imposed on investors by: Allowing the Federal Reserve to permit additional business relationships between investors and a target bank and bank holding company. The Federal Reserve continues to require that business relationships between the minority investor and the banking organization be quantitatively limited and qualitatively nonmaterial, although it may allow more and different types of business relationships between a non-controlling investor and the banking organization where the investor s ownership of voting securities is closer to 10% than 25%. 57

58 APPENDIX C Issues Introduced by Acquisitions from the FDIC Need to coordinate with the FDIC Need to review updates to FDIC FAQs Possible application of the 2009 FDIC Statement of Policy ( SOP ) 10% Tier 1 equity at the insured depository institution Cross support for institutions with common ownership of 80% or greater Limitations on transfer of ownership interest for three years No prior affiliation with a failed depository institution Limitations on transactions between the investors and the insured depository institution 58

59 APPENDIX C FDIC Statement of Policy Generally the SOP applies prospectively to: Private investors in a company, including any company acquired to facilitate bidding on failed banks or thrifts that is proposing to, directly or indirectly, (including through a shelf charter) assume deposit liabilities, or such liabilities and assets, from the resolution of a failed insured depository institution; and Applicants for insurance in the case of de novo charters issued in connection with the resolution of failed insured depository institutions (hereinafter Investors ). This SOP does not apply to acquisitions of failed depository institutions completed prior to its approval date The SOP will not apply to an Investor in a bank or thrift, or bank or thrift holding company where the bank or thrift has maintained a composite CAMELS 1 or 2 rating continuously for seven years 59

60 APPENDIX C FDIC Statement of Policy (continued) In order to provide guidance about the standards for more than de minimis investments in acquirers of deposit liabilities and the operations of failed insured depository institutions, the FDIC has adopted the SOP. The SOP applies to investors and is not intended to interfere with or supplant the pre-existing regulation of holding companies. The FDIC will review the operation and impact of this SOP within six months of its approval date and will make adjustments, as it deems necessary. 60

61 APPENDIX C FDIC Statement of Policy (continued) Capital Commitment: The resulting depository institution shall maintain a ratio of Tier 1 common equity to total assets of at least 10% for a period of three years from the time of acquisition. Thereafter, the depository institution shall maintain no lower level of capital adequacy than well capitalized during the remaining gperiod of ownership of the investors. 61

62 APPENDIX C FDIC Statement of Policy (continued) Cross Support: If one or more investors own 80% or more of two or more banks or thrifts, the stock of the banks or thrifts commonly owned by these investors shall be pledged to the FDIC, and if any one of those owned depository institutions fails, the FDIC may exercise such pledges to the extent necessary to recoup any losses incurred by the FDIC as a result of the bank or thrift failure. The FDIC may waive this pledge requirement where the exercise of the pledge would not result in a decrease in the cost of the bank or thrift failure to the Deposit Insurance Fund. 62

63 APPENDIX C FDIC Statement of Policy (continued) Continuity of Ownership: Investors subject to this policy statement are prohibited from selling or otherwise transferring their securities for three years following the acquisition, absent the FDIC s prior approval. Such approval shall not be unreasonably withheld for transfers to affiliates provided the affiliate agrees to be subject to the conditions applicable under this policy statement to the transferring Investor. These provisions shall not apply to mutual funds defined as an open-ended ended investment company registered under the Investment Company Act of 1940 that issues redeemable securities that allow investors to redeem on demand. 63

64 APPENDIX C FDIC Statement of Policy (continued) Prohibited Structures: Complex and functionally opaque ownership structures in which the beneficial ownership is difficult to ascertain with certainty, the responsible parties for making decisions are not clearly identified, and ownership and control are separated, would be so substantially inconsistent with the principles outlined above as not to be considered as appropriate for approval for ownership of insured depository institutions. Special Owner Bid Limitation: Investors that directly or indirectly hold 10% or more of the equity of a bank or thrift in receivership will not under any circumstances be considered eligible to be a bidder. Transactions With Affiliates: All extensions of credit to Investors, their investment funds, and any affiliates of either, by an insured depository institution acquired by such Investors under this SOP would be prohibited. 64

65 APPENDIX C FDIC Statement of Policy (continued) Secrecy Law Jurisdictions: Investors employing ownership structures utilizing entities that are domiciled in bank secrecy jurisdictions would not be eligible to own a direct or indirect interest in an insured depository institution unless: the Investors are subsidiaries of companies that are subject to comprehensive consolidated supervision as recognized by the Federal Reserve Board, they agree to provide information to the primary federal regulator about the nondomestic Investors operations and activities and maintain their business books and records (or a duplicate) in the United States 65

66 APPENDIX D Regulatory Reform Basel III Capital Capital quality Level of capital Capital conservation buffer Countercyclical buffer Loss absorption at the point of non-viability 66

67 APPENDIX D Regulatory Reform Basel III Capital Quality In practical terms, three types of qualifying capital Tier 1 common equity Tier 1 additional equity Tier 2 capital The emphasis of Basel III plainly is on Tier 1 common equity 67

68 APPENDIX D Regulatory Reform Basel III Capital Quality Tier 1 common equity Bank s common shares meeting criteria for such classification (or equivalent for non-joint stock companies) Stock surplus/share premium on common equity Tier 1 instruments Retained earnings and other disclosed reserves Common shares issued by bank s consolidated subsidiaries and held by third parties (as minority interests) that meet certain additional criteria for inclusion in common equity Tier 1 after regulatory adjustments (deductions) 68

69 APPENDIX D Regulatory Reform Basel III Capital Quality Criteria for common equity The most subordinated claim in liquidation of the bank Entitled to a claim on the residual assets that is proportional with its share of issued capital, after all senior claims have been repaid in liquidation (i.e., has an unlimited and variable claim, not a fixed or capped claim) Principal is perpetual and never repaid outside of liquidation (other than discretionary repurchases or other allowable discretionary capital reductions under relevant law) No expectation is created at issuance that the instrument will be bought back, redeemed or cancelled nor do the statutory or contractual terms provide any feature which might give rise to such an expectation 69

70 APPENDIX D Regulatory Reform Basel III Capital Quality Criteria for common equity Distributions paid out of distributable items and not tied or linked to the amount paid in at issuance and not subject to a contractual cap No circumstances under which the distributions are obligatory y( (no event of default for non-payment) Distributions paid only after all legal/contractual obligations have been met (including payments on more senior capital instruments). Therefore no preferential distributions 70

71 APPENDIX D Regulatory Reform Basel III Capital Quality Criteria for common equity It takes the first and proportionately greatest share of any losses as they occur and absorbs losses on a going concern basis proportionately and pari passu with all the other instruments within the Tier 1 common category The paid-in amount is recognized as equity capital (i.e., not as a liability) for determining balance sheet insolvency The paid-inin amount is classified as equity under the relevant accounting standards It is directly issued and paid-in and the bank cannot directly or indirectly have funded the purchase of the instrument 71

72 APPENDIX D Regulatory Reform Basel III Capital Quality Tier 1 additional capital hybrids To qualify as Tier 1 capital, hybrid instruments must be: subordinated to all depositors and all creditors not secured or guaranteed perpetual, with no incentives to redeem and no investor put option fully discretionary non-cumulative dividends/coupons callable by bank only after 5 years any return of capital only with prior supervisory authorisation capable of principal loss absorption on a going concern basis Several hybrid Tier 1 instruments will be phased out, including step-up instruments, cumulative preferred stock, and trust preferred stock 72

73 APPENDIX D Regulatory Reform Basel III Capital Quality New deductions from Tier 1 capital: Minority interests in consolidated subsidiaries of banks Banks own non-controlling, minority investments in financial institutions Deferred tax assets up to a limit Shortfall in reserves Mortgage serving rights Goodwill and other intangibles Gains on sale in securitization transactions Gains and losses due to changes in banks own credit risk Defined benefit pension fund assets and liabilities 73

74 APPENDIX D Regulatory Reform Basel III Capital Quality Tier 2 Capital Requirements Original maturity of at least 5 years, with no incentive to redeem Callable only by the issuer and only after 5 years, with prior supervisory approval Dividends/Coupons may not have a credit-sensitive dividend feature In liquidation, subordinated to all non-subordinated creditors 74

75 APPENDIX D Regulatory Reform Basel III Level of Capital Minimum common equity Current Basel requirement is 2% New requirement of 3.5% will take effect January 1, 2013, rising to 4.5% by January 1, 2015 Minimum Tier 1 capital Current requirement is 4% Requirement of 4.5% will take effect January 1, 2013, rising to 6% by January 1, 2015 Minimum total capital requirement Remains at 8% New ratios based on more stringent tdefinition iti of capital 75

76 APPENDIX D Regulatory Reform Basel III Conservation Buffer Requires banks to build up capital outside periods of stress which can be drawn down as losses are incurred Ratio of Tier 1 common equity to risk-weighted assets Buffer is phased in in equal increments over three year period, beginning with 0.625% on January 1, 2016 On January 1, 2019, permanent buffer of 2.5% takes effect Restraints on dividends and discretionary bonuses if buffer falls below 2.5% 76

77 APPENDIX D Regulatory Reform Basel III Conservation Buffer Surcharge As part of the capital conservation buffer for 29 global systemically important banks (G-SIBs), BCBS has established an additional loss absorbency surcharge G-SIBs will be allocated initially to four buckets, from 1.0% to 2.5% A fifth bucket of 3.5% has been created as a penalty box Allocations depend on scoring system that takes into account several factors, including levels of cross-border activity, size, interconnectedness, substitutability, and complexity General supervisory judgment is also a factor G-SIBs may use certain instruments in addition to Tier 1 to satisfy surcharge requirement Surcharge phases in between 2016 and

78 APPENDIX D Regulatory Reform Basel III Countercyclical Buffer Buffer is to be employed when excess credit growth is judged to be associated with a build-up of system-wide risk Buffer is an extension of the capital conservation buffer Buffer is set on a national basis; buffers will not be internationally uniform Buffer requirement should be announced 12 months in advance of effective date Phase-in along the same time frame and in the same amounts as conservation buffer Ceiling will be 2.5% as of January 1, 2019 Requirements higher than the phase-in amounts presumably could not be imposed 78

79 APPENDIX D Regulatory Reform Basel III Loss Absorption Contractual terms of instruments should allow for either the permanent writedown of principal or conversion to common equity when a bank is viewed as non-viable Non-viability is when a public sector injection or the equivalent is needed, without which the bank would become non-viable, or a write-off is required, without which the firm would become non-viable Local regulators would have discretion to specify a conversion rate and also whether to implement either a write-off or a conversion EU regulators are considering more onerous bail-in in measures U.S. position on bail-in capital is not fully developed 79

80 APPENDIX D Regulatory Reform Basel III Risk Coverage Securitizations and credit ratings BCBS believes aspects of existing capital framework encouraged investors to place too much reliance on external credit ratings Requirements: Issue-specific rating assessment may only be applied to unrated issues by the same issuer that ranks pari passu or senior to rated issue Banks must develop methodologies to assess credit risk of securitization exposures even if rated Eligibility criteria for entities providing credit protection have been amended Banks should use ratings of credit rating agencies consistently for both risk weighting and risk management purposes 80

81 APPENDIX D Regulatory Reform Basel III Leverage Leverage ratio new to Basel process but well-established in U.S. U.S. requirement already at 4%; 3% for very highly rated banks Lengthy phase-in of 3% ratio; fully effective January 1, 2018 Capital Measure: numerator of the leverage ratio (capital) would consist of only high quality capital that is generally consistent with the revised definition of ftier 1 capital Total Exposure Measure: generally, denominator of the leverage ratio (the total exposures) would be determined in accordance with applicable accounting rules 81

82 APPENDIX D Regulatory Reform Basel III Leverage Ratio Tier 1 leverage ratio to be set at 3% during parallel run period between 2013 and 2017 Bank level disclosure of leverage ratio and components to start in January 2015 Supervisory monitoring period to commence on January 1, 2011 Leverage ratio not to become binding until early 2018 Current proposal is to base leverage ratio on banks capital (the numerator) compared to their exposure (the denominator) on new definition of Tier 1 capital Exposure should follow accounting standards 82

83 APPENDIX D Regulatory Reform Basel III Leverage Ratio High quality liquid assets include cash and cash-like instruments in the measure of exposure Securitisation exposures will be counted in a manner generally consistent with accounting treatment Derivatives exposures will either follow the applicable accounting treatment or use the current exposure method Oh Other off-balance ffb sheets are included: d Commitments Unconditionally cancellable commitments Direct credit substitutes 10% credit conversion factor for any commitments that are unconditionally cancellable at any time by the bank 83

84 APPENDIX D Regulatory Reform Basel III Liquidity Liquidity requirements under Basel II consist of two key liquidity ratios: Liquidity Coverage Ratio, which is a short term measure of liquidity Net Stable Funding Ratio, which is a medium term measurement of liquidity 84

85 APPENDIX D Regulatory Reform Basel III Liquidity Liquidity Coverage Ratio Ratio: Ratio of high quality liquid assets to total net cash outflows over next 30 days Must be equal to or greater than 100% Inflows capped at 75% of outflows Builds on traditional internal methodologies used by banks to assess exposure to contingent liability events Defined as stock of high quality liquid assets divided by total net cash outflows for next 30 days Certain high quality liquid assets ( level 1 assets ) to be included on asset side on an unlimited undiscounted basis Level 2 assets must comprise no more than 40% of the overall stock and must have a minimum 15% haircut Observation period for liquidity coverage ratio commences in 2011 and ratio to be introduced at start of

86 APPENDIX D Regulatory Reform Basel III Liquidity Net Stable Funding Ratio Final version has been published but still under discussion Net stable funding ratio: Ratio of available amount of stable funding ( ASF ) ASF) to required amount of stable funding ( RSF ) Must exceed 100% Designed to promote resilience over a period of one year Builds on net liquid asset and cash capital methodologies used by internationally active banks Ratio should be reported at least quarterly Minimum standard will be required by January 1,

87 APPENDIX D Regulatory Reform Basel III U.S. Implementation Basel III tasks for U.S. regulators Capital surcharges for systemically important financial firms Coordination with Basel Committee on identification of, and surcharges for, G- SIBs More stringent capital requirements for large U.S. banking organizations consistent with the requirements of the Dodd-Frank Act Impact of Basel III on the larger U.S. banking community Will there be a trickle-down effect from Basel III to the U.S. banking system in general? Most likely trickle-down effect: components of Tier 1 and Tier 2 capital 87